What Happens to a 529 If You Get a Scholarship?

If you get a scholarship, your 529 plan does not go to waste and you are not stuck paying a penalty to access the money. Federal law lets you withdraw up to the scholarship amount from the 529 without the usual 10% penalty on earnings. The earnings portion of that withdrawal is still taxed as ordinary income, but the surcharge disappears. You also have options that avoid a taxable withdrawal entirely, from changing the beneficiary to rolling funds into a Roth IRA.

How Much You Can Withdraw Penalty-Free

Any 529 distribution not spent on qualified education expenses normally triggers a 10% additional tax on the earnings portion. When the beneficiary receives a scholarship, the tax code carves out an exception: you can withdraw up to the scholarship amount without the 10% hit.¹

The math is straightforward. A $15,000 scholarship supports up to a $15,000 penalty-free withdrawal in that tax year. Anything you pull out beyond the scholarship that also isn’t spent on qualified expenses gets the full 10% penalty on the earnings portion.²

The waiver applies to the earnings component. Your original contributions were already taxed before going into the account, so principal was never subject to the penalty to begin with.

What Counts as a Scholarship

The exception is broader than merit awards. The statute extends the same treatment to veterans’ educational assistance and employer-provided educational assistance under Section 127.¹ IRS Publication 970 also lists Pell grants and other tax-free educational assistance as qualifying awards.³

If a student gets more than one type of qualifying assistance, the penalty-free withdrawal cap is the total. A $5,000 scholarship plus $3,000 in employer tuition assistance supports an $8,000 penalty-free withdrawal.

What You Still Owe in Tax

Avoiding the penalty is not the same as avoiding tax. The earnings portion of a scholarship-related withdrawal is still taxable as ordinary income to whoever receives the distribution.² Every 529 distribution mixes contributions and investment growth in the same proportion the account holds. Contributions come back tax-free. Earnings do not.

Your plan administrator reports the split on Form 1099-Q. Box 1 is the total distribution, Box 2 is the earnings, and Box 3 is the return of contributions. Because 529 earnings are taxed at ordinary rates rather than capital gains rates, your effective rate depends on the recipient’s overall taxable income for the year.

Who owes the tax depends on who received the check. If the distribution goes to the beneficiary, the student reports the income, usually at a lower marginal rate than a parent would pay. If the distribution goes to the account owner, the owner reports it. Confirm the payee before filing, because it decides which return carries the earnings.

Don’t Blow the American Opportunity Tax Credit

The IRS enforces a strict “no double benefit” rule: the same tuition dollars cannot support both a tax-free 529 distribution and an education tax credit.³

The American Opportunity Tax Credit is worth up to $2,500 per eligible student and requires $4,000 in qualified expenses to claim the full amount. From total qualified expenses, you subtract tax-free educational assistance (scholarships, grants, employer help) and then subtract the expenses you used for the credit. Only what remains can be covered tax-free by 529 withdrawals.³

One strategy is worth running the numbers on. If qualified expenses minus the scholarship fall below $4,000, having the student voluntarily include part of the scholarship in gross income frees up expenses for the credit. Whether the extra tax the student pays is less than the credit gained depends on the student’s bracket. Calculate both ways before filing.

How to Report It

The beneficiary reports the taxable earnings on Schedule 1 of Form 1040, line 8z, as QTP earnings.³ To claim the scholarship penalty exception, file Form 5329. Part II handles the additional tax on education-account distributions, and line 6 is where you enter the amount excluded because it was attributable to a scholarship or other qualifying award.⁴

Two documents matter. Form 1099-Q from the 529 administrator gives you the earnings-versus-contribution split. Form 1098-T from the school shows tuition paid and scholarships received. Comparing them lets you verify that the amount you are excluding from the penalty matches what was actually awarded. Keep the original scholarship award letter as well; the IRS may ask for it in an audit.

If the School Refunds Tuition, Use the 60-Day Rule

Sometimes a scholarship posts after you have already paid tuition from the 529, and the school issues a refund. If you keep it, the IRS can treat it as a non-qualified distribution subject to both tax and the 10% penalty. IRS Notice 2018-58 lets you recontribute the refund to a 529 for the same beneficiary within 60 days of receiving it, and the distribution is treated as though it never happened.⁵

The recontributed amount is treated entirely as principal, so you don’t have to calculate an earnings split. It doesn’t count against the plan’s contribution limits, and it can go into a different 529 than the one it came from, as long as the beneficiary is the same person.⁵ The 60-day deadline is firm. Miss it by a day and the option is gone.

Alternatives to Withdrawing at All

Pulling money out is one option, not the only one. Keeping funds inside the tax-advantaged account often produces a better long-term result than cashing out and paying income tax on the earnings.

Change the Beneficiary

You can move the 529 to another qualifying family member without triggering tax or penalty. Eligible recipients include the original beneficiary’s siblings, parents, first cousins, nieces, nephews, and the account owner.¹ The funds stay invested and can be used later for college, graduate school, or any other qualified education expense. If you have younger children or eligible relatives, this is usually the simplest move.

Roll Excess Funds into a Roth IRA

The SECURE 2.0 Act created a route to roll unused 529 funds into a Roth IRA for the beneficiary, tax-free and penalty-free. The rules are tight. The 529 must have been open at least 15 years.¹ Contributions made in the last five years are ineligible. Annual rollovers can’t exceed the Roth IRA contribution limit, which for 2026 is $7,500 for those under age 50.⁶ The lifetime cap is $35,000 per beneficiary across all 529 accounts.

Watch one wrinkle: changing the beneficiary likely resets the 15-year clock. A sibling who took over the account last year starts the 15-year period from the transfer date, not from when the account was originally opened.

Hold It for Graduate School or Later Education

529 funds do not expire. Qualified expenses extend past a four-year undergraduate degree to graduate school, professional certifications, registered apprenticeships, and up to $10,000 in student loan repayment.² If the beneficiary might pursue an MBA, law school, medical school, or a trade credential later, leaving the money invested preserves the tax-deferred growth.

Check Your State’s Recapture Rules First

Federal rules get most of the attention, but state tax can add a hidden cost. More than 30 states offer an income tax deduction or credit for 529 contributions, and many of those same states require you to recapture the benefit if you later take a non-qualified withdrawal. The amount you previously deducted gets added back to your state taxable income the year you withdraw.

Whether the federal scholarship exception also spares you from state recapture depends entirely on your state. Some states mirror the federal treatment and waive recapture for scholarship-related withdrawals. Others don’t distinguish. Confirm your state’s rules before pulling the money out, because a state recapture you didn’t plan for can undo the benefit of skipping the federal penalty.

1
Office of the Law Revision Counsel. 26 USC 529 – Qualified Tuition Programs
2
Internal Revenue Service. Topic No. 313, Qualified Tuition Programs (QTPs)
3
Internal Revenue Service. Publication 970, Tax Benefits for Education
4
Internal Revenue Service. 2025 Instructions for Form 5329
5
IRS.gov. Guidance on Recontributions, Rollovers and Qualified Higher Education Expenses Under Section 529 Notice 2018-58
6
Internal Revenue Service. 401(k) Limit Increases to $24,500 for 2026, IRA Limit Increases to $7,500